Are hedge funds going to be the next bubble?

Financial markets have always been prone to fashions and fads. Some smart investors simply try to spot the latest craze and make money by riding the wave of euphoria and relying on the "bigger fool" theory of asset pricing: there will always be an idiot to buy this from me at a higher price than I paid for it.

The technology bubble of the late 1990s is a contemporary example but history is littered with dozens of similar episodes. Tulip mania in 17th century Holland saw a single Semper Augustus bulb change hands, in 1636, for 4,600 florins, a new carriage, two grey horses and a complete set of harness. The fact that 4,600 florins could also have bought 500 sheep gives us an idea about how far this particular mania had run. And it ended like all asset price bubbles, bringing ruin to the majority of market participants.

Warren Buffett, often described as the world's greatest investor, has described the current popularity of hedge funds as another market fad. Whether he thinks that people who invest in these mysterious entities are making the same mistake as the Dutch did in the early 17th century is not clear but he almost certainly believes that a lot of people are going to lose a lot of money.

We see similar sentiments expressed by many orthodox commentators. Philip Coggan, a prominent UK financial journalist, has warned many times about probable disappointment ahead for hedge funds' investors.

Are these pessimists right? Should ordinary punters avoid hedge funds?

One of the many problems associated with "alternative investing" is that it is extremely tough to define. Hedge funds and many other types of asset managers attract the label "alternative", mostly because the investment strategies they pursue are very different to the more familiar approaches adopted by the big pension funds and insurance companies.

A simple distinction relates to the objectives of the fund: a traditional asset manager sees his job as beating some benchmark, say the S&P 500 in the US or the FTSE All-Share Index in the UK: a relative objective. An alternative manager sets himself an absolute standard, a common example being 15 per cent.

The traditional asset manager is happy provided he beats his benchmark and is quite content to deliver negative returns provided they are not as bad as the index he is being compared with. The alternative asset manager is only happy if he generates a positive 15 per cent or greater.

Analysts such as Mr Coggan are quick to point out that it stretches credulity to believe that large numbers of people managing ever larger sums of money can all meet these absolute performance standards. Markets simply don't operate in this way.

We don't have to appeal to theoretical notions of market efficiency: asset pricing would have to be always and everywhere completely off the wall to generate the opportunities for loads of people to achieve returns of 15 per cent or more consistently over many years.

The subtle point here is that it may be possible for some very smart people to do this but, as hedge funds rapidly move into the mainstream, it is very unlikely that the majority of them will achieve their objectives.

Alternative money managers invest in anything, have differing investment philosophies, sometimes use lots of leverage, sometimes make extensive use of derivatives. Traditional asset managers are much more constrained.

Critics of hedge funds often assume that this must mean far too much risk is taken. This can be true (recall Long-Term Capital Management) but it is not necessarily the case. Indeed, it is possible that operating in an unconstrained way can reduce the riskiness of investments by increasing the hedging opportunities. If an equity fund manger is worried about oil prices, all he can do is sell some of his equities; a hedge fund can buy oil.

There are many other types of asset management companies offering their services, increasingly to the private investor. Previously available only to the institutional investor, managed futures, private equity funds, venture capital funds and other vehicles are becoming more accessible. A popular way for the small investor to gain access is via a fund-of-funds, where a specialist provider combines a group of hedge funds (or other alternative managers) into a single investment product.

At this point, most savvy investors will have guessed another key difference between traditional and alternative money managers; the fees that are charged. It is common to see hedge funds say they charge a 1-2 per cent management fee (levied annually on the amount of money invested) and 20 per cent of all investment returns.

Larger clients can often negotiate these fees down but smaller investors usually have to accept them - and if the fund-of-fund route is chosen there is at least one additional layer of fat fees incurred.

For the private investor, used to high charges, the management fee will not seem that unusual. But a large pension fund, used to paying around 0.3 per cent annual management fees, often balks at the higher hedge fund charge. And very few traditional asset managers charge anything for performance, although this may change in the years ahead.

It is often said that alternative asset managers have a huge advantage over their traditional cousins because they are unregulated. I'm not sure where this notion comes from, because it is untrue.

Hedge funds are regulated in a different way but they are not unregulated. But the confusion over regulation - and the differences between different countries - means that hedge funds have a lesser prudential reputation than mainstream managers. I'm not sure that this is fully deserved, but regulation is getting tighter in most jurisdictions.

Like tulip bulbs, the best time for investing in hedge funds was when few people had the same idea. But for a relatively small part of an individual portfolio, the alternative world is still worth a look.

Anybody thinking about putting money into hedge funds should be prepared to do as much due diligence as the professionals - ask a lot of very detailed questions about all aspects of the business, not just its performance track record.

A fund-of-fund route will short-circuit some of this but you still have to be able to identify the best providers. And that involves a lot of homework.

Hedge funds are becoming mainstream. Some of them will continue to make large amounts of money - but only some.